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Tag: too big to fail

The profits being reported so far this year by the major financial firms appear to be driven by proprietary trading (trading for their own account, as opposed to those of their customers). The recent $3.44 billion profit of Goldman Sachs in the second quarter is a dramatic case in point.

Proprietary trading is a high-risk activity and signals the financial sector is returning to its bad old ways. Returns cannot be systematically high unless risk is correspondingly high.

None of this would matter if it were just private capital at stake. But Goldman, along with other major financial firms, is being guaranteed under the dubious doctrine that it is too-big-to-fail. Better there were no government guarantees. As long as these guarantees are in place, however, high-risk activity must be curtailed.

The simplest solution is that a firm should not be permitted to take insured deposits and operate what amounts to a hedge fund within the institution. Goldman is a difficult case because it is not currently relying on deposits (even though it has a bank charter). It should be told to return to a private partnership.

One of the most pernicious public policies aggravating the financial crisis is that of “too big to fail.” The doctrine states that some banks (now financial institutions generally) are so large that their failure would incur “systemic risk” for the financial system. That sounds terrible and it is intended to. Financial services regulators and Treasury secretaries use it to frighten small children and congressmen. How can an elected official vote to incur systemic risk? He must vote to approve the bank bailout of the day. In fact, people who use the term cannot even agree among themselves as to what it means, much less what causes it and, therefore, what the appropriate response would be. I suggest the reader substitute the phrase “too politically connected to fail” whenever he sees “too big to fail.” What follows will then be rendered intelligible.

What is to be done with the nation’s largest financial institutions, 19 of which have been officially designated as “too big to fail?” When thus guaranteed government protection, such institutions can be expected to take excessive risk and generally operate recklessly. Profits on risky ventures remain privatized, while losses become socialized. That is what happens when you bet with other people’s (that is, taxpayers’) money. I have called the system “casino capitalism.”

The solution, of course, is to end the policy of “too big to fail.” That will not happen soon, however, and we will likely see the government’s safety net extended to more institutions before there is any prospect for its withdrawal. In the interim, the risk-taking appetite of the large banks must be constrained, that is, regulated. What should the classical liberal response be?

MIT’s Simon Johnson has argued, “Anything that is too big to fail is too big to exist.” He favors breaking these institutions up. Chicago’s Gary Becker has suggested imposing progressive capital requirements as a disincentive for financial services firms to grow large enough to become too big to fail. The larger the institution, the higher the required capital ratio.

What cannot in conscience be done is to apply presumptive free-market arguments to such entities. They are not being constrained by market forces. The market’s invisible hand has been replaced by the state’s protective embrace.